I am the sole owner of my business, and I am planning to retire within the next five years. I have considered an employee stock ownership plan, (ESOP) as one of my succession options. Will you explain the benefits and risks?
We applaud you for considering your succession plan from a variety of angles, including an ESOP. We often hear from our clients their desire to see their employees working as though they too owned the company, and an ESOP (Employee Stock Option Plan) accomplishes just that.
Under an ESOP, employee participants take part ownership of the company through a retirement savings arrangement. Meanwhile, the business and its existing owner(s) can benefit from some tax breaks, an extra-motivated workforce and potentially, an effective succession plan.
How does an ESOP work?
To implement an ESOP, you establish a trust fund and either: contribute shares of stock or money to buy the stock (an “unleveraged” ESOP), or, borrow funds to initially buy the stock, and then contribute cash to the plan to enable it to repay the loan (a “leveraged” ESOP).
The shares in the trust are allocated to individual employees’ accounts, often using a formula based on their respective compensation. The business must formally adopt the plan and submit plan documents to the IRS, along with certain other forms.
What’s the tax impact?
There are a few, but among the biggest benefits of an ESOP is that contributions to qualified retirement plans such as ESOPs typically are tax-deductible for employers. However, employer contributions to all defined contribution plans, including ESOPs, are generally limited to 25% of covered payroll. But C corporations with leveraged ESOPs can deduct contributions used to pay interest on the loans. That is, the interest isn’t counted toward the 25% limit.
Dividends paid on ESOP stock passed through to employees or used to repay an ESOP loan may be tax-deductible for C corporations, so long as they are reasonable.
In another potential benefit, shareholders in some closely held C corporations can sell stock to the ESOP and defer federal income taxes on any gains from the sale, with several stipulations. One is that the ESOP must own at least 30% of the company’s stock immediately after the sale. In addition, the sellers must reinvest the proceeds (or an equivalent amount) in qualified replacement property securities of domestic operation corporations within a set period.
Finally, when a business owner is ready to retire or otherwise depart the company, the business can make tax-deductible contributions to the ESOP to buy out the departing owner’s shares or have the ESOP borrow money to buy the shares.
Are there risks?
An ESOP’s tax impact for entity types other than C corporations varies somewhat from what we’ve discussed here. And while an ESOP offers many potential benefits, it also presents risks such as complexity of setup and administration, and in some situations, a strain on cash flow.